Agency and Principal Transactions

January 1, 2012

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The SEC has defined a cross trade as a transaction between two accounts managed by the same RIA. Principal and agency transactions are of particular concern. In passing Section 206(3) of the Investment Advisers Act, Congress recognized that principal and agency transactions are potentially harmful to clients. Such transactions create the opportunity for RIAs to engage in self-dealing. An RIA can execute a cross trade on an agency or principal basis.

A principal transaction is a situation where an RIA acts as a principal for its own account and knowingly sells securities to, or buys securities from, a client. A principal transaction also includes situations where an affiliate or controlling person of an RIA engages in a trade with an advisory client. These transactions may lead to abuses, such as price manipulation, and the placement of unwanted securities in clients’ accounts—a practice known as “dumping.” Principal trading with clients represents a clear conflict of interest that must be disclosed to customers.

An agency transaction occurs when an RIA arranges a trade between different advisory clients. In other types of agency transactions, an RIA arranges a trade between a brokerage customer and an advisory client. One danger with agency transactions is an unethical investment advisor arranging an agency trade benefiting one client to the detriment of another. For example, if an advisor has a client with twenty million in assets under management, the firm might arrange an agency transaction potentially hurting a client who only has one million dollars in assets under management. Additionally, if one client pays performance fees and another does not, agency transactions might give an RIA the opportunity to earn additional compensation.

Principal and Agency Transactions

Although there is no prohibition from engaging in principal and agency transactions, RIAs must satisfy a disclosure and client consent requirement. Certain types of cross trades require full compliance with Rule 206(3)-2 under the Investment Advisers Act. With principal transactions, an RIA, acting for its own account, buys a security from or sells a security to, the account of a client.

Section 206(3) of the Investment Advisers Act applies to both state and SEC registered advisors. This section makes it unlawful for any RIA acting as a principal for its own account to knowingly sell any security to, or purchase any security from, clients without written disclosure of the capacity in which the firm is acting before the completion of the transaction. The RIA must also obtain the client’s consent. The Rule 206(3)-2 exemption from the prohibitions of Section 206(3) is available to all state and SEC-registered investment advisors.

Compliance with Rule 206(3)-2

Compliance with Rule 206(3)-2 is required in any transaction in which an RIA, or any person controlling, controlled by, or under common control with this RIA, acts as broker for both the advisory client and the other party to the transaction. The SEC has taken the position that Rule 206(3)-2 applies to both agency cross trades and principal transactions.

Compliance with Rule 206(3)-2 requires an RIA to satisfy all of the following:

The advisory client must execute written consent in advance of the trade authorizing agency cross transactions. This written consent must come after full written disclosure that the RIA, or some other person, acts as a broker for, receives commissions from, and has potentially conflicting division of loyalties and responsibilities to both parties to the transaction.

The RIA must send each client a written confirmation at or before the completion of each transaction that includes (i) a statement of the nature of this transaction, (ii) the date this transaction took place, (iii) an offer to furnish, upon request, the time when this transaction took place, and (iv) the source and amount of any other remuneration received or to be received by the RIA. This confirmation would take place prior to settlement, but after execution, and a transaction is not complete until the settlement takes place.

The RIA must send each client an annual statement identifying the total number of these transactions since the last summary and the total amount of all remuneration received or expected by the RIA. Each written statement must conspicuously disclose that the client’s consent may be revoked.

Prior disclosure and consent requirements for principal transactions are slightly different from agency cross transactions. These requirements must be met prior to completion of every principal transaction. It is not enough to have a blanket written consent that is given in advance by the client at the beginning of the advisory relationship. Furthermore, disclosure in the RIA’s Form ADV is not sufficient.

Even if an advisory firm fully complies with Rule 206(3)-2, the RIA is not relieved from acting in the best interests of the client. The RIA’s fiduciary duty encompasses its obligations regarding best price and execution for the particular transaction. The RIA must also comply with its disclosure obligation under subparagraphs (1) or (2) of section 206 of the Investment Advisers Act and other applicable provisions of the federal securities laws.

Noncompliance Is a Bad Idea

As we discussed in The Need for Thorough and Effective Policies and Procedures, the SEC charged three advisory firms on November 28, 2011, with failing to implement policies and procedures designed to prevent securities law violations and harm to investors. One of the firms, a Minneapolis RIA/broker-dealer, engaged in hundreds of principal transactions with its advisory clients’ accounts without making the required disclosures and obtaining the consent required by Section 206(3) of the Investment Advisers Act. The firm also committed other violations, such as failing to adopt a code of ethics.

Pursuant to a settlement, the Minneapolis firm agreed to pay a $50,000 penalty and refund more than $142,000 to advisory clients, and agreed to hire an independent consultant to review its compliance operations annually for two years. Subsequently, the firm was required to provide a copy of the SEC’s order to past, present and future clients and to post a summary of the order on its website in a prominent spot.

On May 27, 2011, the SEC issued an order instituting administrative and cease-and-desist proceedings against Wunderlich Securities Inc. (WSI) and others for numerous violations of the Investment Advisers Act. According to the order, WSI knowingly effected thousands of securities transactions for advisory clients while acting as a principal for its own account. WSI was required to disclose to these clients in writing before the completion of each transaction that the firm was acting as a principal. WSI and its CCO failed to satisfy the disclosure and consent requirements required by Section 206(3) of the Investment Advisers Act.

WSI profited from these principal trades, because it received commissions in connection with the trades, along with mark-ups or mark-downs. Among other violations, the firm’s CCO failed to take reasonable steps to ascertain whether WSI had written policies and procedures designed to ensure compliance with Rule 206(3) when engaging in principal trades.

Impact of IA-1732 on Agency and Principal Transactions

In an Interpretative Release (Release No. IA-1732), the SEC made it clear that Rule 206(3)-2 does not apply if an RIA receives no compensation other than its advisory fee for effecting a particular agency transaction between clients. The rationale is that since no compensation over and above the advisory fee is earned, the RIA does not have the type of conflict of interest that sparked Congress to pass Section 206(3) of the Investment Advisers Act, and the SEC to implement Rule 206(3)-2.

In IA-1732, the SEC took the position that an RIA may satisfy Rule 206(3)-2 by obtaining client consent to a principal or agency transaction after execution, but prior to settlement of the transaction. According to this interpretation, post-execution and pre-settlement consent is generally effective, as long as the RIA has not structured the procedures for obtaining consent in a manner that forces the client to agree to the transaction. The SEC reasoned that a securities transaction is completed upon settlement, not upon execution.

In IA-1732, the SEC suggested two different ways for RIAs to obtain consent and comply with Rule 206(3)-2:

Prior to obtaining pre-execution consent, an RIA can transmit to the client the current quoted price for a proposed transaction and, if applicable, current best price information. Under these circumstances, assuming clients have been informed about the potential conflicts of interest and have consented to a proposed transaction before it is executed, the RIA has satisfied its disclosure obligation under Rule 206(3)-2.

The alternative is obtaining post-execution and pre-settlement consent. Prior to settlement, the client receives the appropriate information to make an informed decision and agrees to the transaction.

Complying with Rule 206(3)-2 is not enough. An RIA’s Form ADV must clearly disclose to clients that cross trades may occur. RIAs must ensure that there is full compliance with their policies and procedures related to cross trades.

Alternative Rule for RIAs Registered as Broker-Dealers to Comply with Rule 206(3)-3T

In late December 2010, the SEC amended Rule 206(3)-3T under the Investment Advisers Act, a temporary rule that established an alternative means for RIAs registered as broker-dealers to satisfy their cross trading obligations. The rule permits dually-registered RIAs/broker-dealers to conduct principal trades in certain securities for clients with non-discretionary advisory accounts, as long as an annual blanket consent form has been signed. Otherwise RIAs/broker-dealers would need to obtain trade-by-trade consent.

Thanks to the amendment, Rule 206(3)-3T is now scheduled to expire on December 31, 2012 instead of December 30, 2010. The extension was adopted, so the SEC could continue to study whether it provides sufficient protection to advisory clients.

The Big Picture

The SEC’s interpretation only applies to an RIA’s disclosure obligations under Section 206(3) of the Investment Advisers Act. Other provisions of the federal securities laws, such as the antifraud provisions of the Securities Exchange Act of 1934 (Exchange Act), require that material information about certain transactions be communicated to investors prior to executing the transaction.

Section 913(g) of the Dodd-Frank Act required that the standard of conduct applicable to broker-dealers should be no less stringent than Sections 206(1) and 206(2) of the Investment Advisers Act. As required by the Dodd-Frank Act, the SEC published a study in January 2011 addressing how broker-dealers should fulfill the uniform fiduciary standard when engaging in principal trading. Although the uniform fiduciary standard is likely to impact certain aspects of principal trading, several experts believe it will not impose Section 206(3) of the Investment Advisers Act on broker-dealers. In its study, the SEC said, the “omission of a reference to Section 206(3) appears to reflect a Congressional intent not to mandate the application of that provision to broker-dealers when providing personalized investment advice about securities to retail investors (though granting the Commission the authority to impose such restrictions).”

The study made the following recommendation: “The Commission should address through guidance and/or rulemaking how broker-dealers should fulfill the uniform fiduciary standard when engaging in principal trading.” Assuming the uniform fiduciary standard is adopted, the SEC seems to recognize that it must be tailored to the broker-dealer business model, which is much different from RIAs’.

Les Abromovitz

Les Abromovitz is the author of The Investment Advisor’s Compliance Guide, published for 2012 by The National Underwriter Company/Summit Business Media. Les Abromovitz is an attorney and member of the Pennsylvania bar. Les has handled hundreds of consulting and publishing project for a leading compliance and regulatory services firm. He has conducted a number of seminars and training sessions dealing with compliance subjects. Les is also the author of several White Papers that analyze compliance issues impacting Registered Investment Advisors (RIAs).

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